An attempt to demystify the process of raising capital, democratize information and help entrepreneurs improve their businesses by avoiding the mistakes that I've already made... and occasionally include a personal post because Rich told me to.

Wednesday, August 02, 2006

Pricing: Value not Cost

Last week I bought tickets to a baseball game through the Oakland A's website. I found the tickets that I wanted, which were $30 each. I clicked through to buy and was informed of a $5 per ticket convenience charge. I clicked again to continue and was informed of a $3.75 order processing fee. Finally, I got to the checkout where I was informed that printing out the tickets at home would cost an additional $2.50, which I did. The actual cost of my $30 tickets had risen 27% to $38.18. I was frustrated that A's were charging me such a high premium to buy tickets online when it cost them next to nothing to facilitate the transaction. In fact, in the case of printing my tickets at home, I was saving them the cost of printing, yet, they were charging me for the privilege. If A's priced online ticket sales based on cost there likely would be no convenience fees at all. Yet, the A's priced their various fees based on value. It was simply much more convenient for me to pay the fees than to drive to the Oakland Coliseum days before the game or wait in line and risk not getting the seats I wanted at game time. While, paying the extra $8 per ticket was annoying, it does demonstrate a key lesson about product pricing.

As a startup developing a new product, pricing is often difficult to gauge. How much will customers pay and how much can I get away with charging them? The balances is between not wanting to leave revenue on the table and not wanting to scare off prospective customers with high prices. One common mistake is to price a product on its cost of manufacturing and delivery. However, this often leads to under (or worse yet, over) pricing. The best way to price a product is emulate the Oakland A's and price based on value proposition to the customer.

Pricing based on cost rarely if ever makes sense. Consider software licensing, where it costs the vendor almost nothing to issue another copy. If Microsoft based their pricing on costs, they would be giving away copies of Windows and Office by now because the costs of licensing another copy are very low. Sometimes pricing based on cost can lead to a product that is too expensive, which is the kiss of death. If the cost of production is higher than the value delivered than the product is really in trouble, which is why attempting to understand the value proposition is so important prior to creating the product.

Value proposition is the most efficient way to price a product while minimizing revenue left on the table. Value proposition is typically based on a cost savings or productivity increases perceived by customers. Cost savings might be related to reduced labor, risk, electricity or some other raw material. Increased productivity is typically related to better access to information or increased sales. In some cases the value proposition can be made but it is still hard to determine a price. While it does require a degree of finesse asking beta partners or prospective customers what they would be willing pay can provide a ball park idea of how to price.

Pricing based on value proposition gets easier when a startup is building "a better mouse trap" as an alternative to existing competition. For example, if the startup is building a new chip that delivers the same performance as existing competition but requires far less electricity, the price of the new chip should be a premium on the old chip based on the electricity savings. The pricing premium cannot reflect the entire electricity cost savings otherwise the customer won't receive any benefit* and they won't have any more incentive to purchase the more efficient chip. Thus, an effective price based on value proposition rewards the vendor but still allows the customer reap significant benefits.

Brand and discounting also play a significant role in pricing based on value proposition. Simply put, many customers perceive brand to a part of a product's value proposition. The mentality of "nobody ever got fired for buying IBM" demonstrates that many individuals and organizations want the stability of a large company backing the product. Thus, many startup products that objectively offer more benefits are often priced below established competitors because the customer's decision-making individuals need an incentive to justify taking on the additional "risks" associated with purchasing a product from a small company.

Lastly, many products value propositions are not perceived equally across the market. It is common for the same product to be "need to have" to one customer, while only "nice to have" to another. This is where the game of discounting comes in because discounting allows a vendor to hide the fact that one customer paid more for the same product than another. Discounting is essentially price discrimination based on a negotiation between how badly the vendor wants to close the sale and how value the customer perceives in the product. Furthermore, It is much easier to lower an established price than it is to raise and established price, which is why it is so common for IT products to regularly sell at significant discounts.

1 Comments:

I love your thought process, but I do think you oversimplified pricing a tech product.

Yes you have value and cost, but you left out volume.

Microsoft could have charged $5,000 per copy of Windows and it would have sold a substantial ammount to large companies, but by pricing it within reach of small businesses and individuals, and below the actual "value" line, it was able to more then make up for the lost revenue in volume...